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What Is a Certificate of Deposit (CD)?


Written by Michelle Lambright Black | Edited by Rebecca Stropoli | Published on 6/28/2024

 

A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate for a specific amount of time. In many cases, CD rates are higher than the interest rates on standard savings accounts. But in exchange, you must agree not to withdraw the cash you deposit in the account until the CD matures. Otherwise, you’ll incur a penalty.

Here’s more about how CDs work and the pros and cons of these types of accounts. You’ll also learn how to determine when opening a CD could be a good financial strategy, how to compare CDs and which CD alternatives you might want to consider.

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How does a CD work?

When you open a CD with a bank, you agree to leave your cash in the account for a set period of time. CD terms may range from a month up to several years. Whatever term you choose, avoid making any withdrawals until your CD matures.

Credit unions offer CDs as well but typically call these types of accounts share certificates.

At the end of a CD’s term, you can access the money you deposited plus any interest earned. Technically, you can access your money at any time. But if you take cash out of your CD before the maturity date, your bank or credit union will most likely charge you an early withdrawal penalty, which could offset some or all of your earnings.

In general, CDs are considered a safe savings option. The interest rate on most CDs is fixed. As long as you don’t take money out of your account early, you can know ahead of time how much interest you’ll earn.

If you open a CD with a bank that’s a member of the Federal Deposit Insurance Corp. (FDIC), you’ll have an FDIC-insured CD. CDs from credit unions that are members of the National Credit Union Administration (NCUA) offer NCUA insurance. Both types of CDs are federally insured for up to $250,000.

CD rate trends

According to the FDIC, rates on many CD products are higher than they were at this time last year. Yet the Federal Reserve has indicated that it may cut the federal funds rate before the end of the year. If you’re considering putting money into a CD for short- or mid-term savings goals, now might be a good time to make a move.

 

CD pros and cons

Before you open a CD at a bank or credit union, consider the benefits and drawbacks these accounts offer.

Pros Cons
  • Higher APYs compared with traditional savings accounts
  • Fixed interest rates
  • No monthly maintenance fees on most accounts
  • No access to cash without a penalty
  • CD rates may not keep pace with inflation
  • Other investments may produce better returns

Pros explained

  • Higher APYs compared with traditional savings accounts: In general, CDs tend to feature higher annual percentage yields (APYs) than traditional savings accounts. You may find some high-yield savings accounts with interest rates that rival CDs. But keep in mind that interest rates on these accounts typically aren’t fixed.
  • Fixed interest rates: Most financial institutions offer fixed interest rates on their CDs. As a result, you can know exactly how much interest you will earn with this low-risk savings product.
  • No monthly maintenance fees on most CDs: If you open a savings or money market account, you’re more likely to encounter additional expenses.

Cons explained

  • No access to cash without a penalty: When you open a CD, a bank or credit union will require you to leave your cash in the account for a set period of time, or a term. If you decide to withdraw money from your CD before the maturity date arrives, the financial institution will generally charge you an early withdrawal penalty. Early withdrawal penalties differ depending on the terms of your account. But they could wipe out a large portion of your interest earnings and, in rare cases, all of the interest a bank has paid you.
  • CD rates may not keep pace with inflation: Your savings may be eroded by inflation.
  • Other investments may produce higher returns: Your yield could be greater if you invested in stocks or mutual funds, but these are also riskier options.

When could opening a CD be a good strategy?

A CD isn’t a perfect solution for every saver. But it could be a good place to store your money in certain situations. Below are some examples of times you might want to consider a CD.

When interest rates are high

When the Federal Reserve raises interest rates, banks and credit unions tend to offer higher APYs on CDs and other deposit accounts in response. Typically, the best time to open a CD is when interest rates are high — especially if you suspect rates may be near their peak.

When you’re saving for a big purchase

With a CD, you agree to not withdraw cash from your account for a set amount of time. This type of arrangement could work well if you’re saving money for a large purchase and you don’t need to access your cash before the CD’s term is up.

When you’re averse to risk

Because CDs offer guaranteed returns, they may be a good fit if you prefer a low-risk option to grow your savings. Although CDs traditionally offer lower returns than some other types of investments, you don’t have to worry about the risk of losing your money in an unpredictable stock market.

How to compare CDs

Compare multiple products as you shop for CDs to choose one that can help you reach your financial goals. Below are some of the factors to consider:

Terms. CD terms commonly range from a few months to five years. Many times, CDs with longer terms feature higher interest rates than those with shorter terms. But that’s not always the case. That’s why doing your research is important.

Types. Another detail to consider is the type of CD you want to open. Some CDs have special features, such as bump-up CDs that let you request a rate increase if your bank raises interest rates before your CD matures. A no-penalty CD is another option that allows you to withdraw cash early without paying a fee. However, CDs with special features often feature lower interest rates than standard CDs.

Rates. One of the most important details you’ll want to research when you compare CD options is the rates that different banks and credit unions offer. A higher CD rate can help you earn more money on your savings.

Deposit amounts. Some banks may require you to deposit a minimum amount of money to open a CD or a certain amount of money to qualify for different interest rate tiers. Makse sure you find CDs with deposit requirements that suit your needs.

CD alternatives

Although CDs are a popular option among savers, you’ll still want to review CD alternatives before you make a final decision about the best fit for your financial needs.

High-yield savings account

This is similar to a traditional savings account but with an APY that tends to be higher than the national average. Compared with some CDs, however, the interest rates on high-yield savings accounts may be slightly less competitive.

With this account, you can access your cash on an as-needed basis. A high-yield savings account could be a good fit for emergency funds or other types of savings goals that may require frequent withdrawals. Interest rates are not fixed, however.

Money market account

Money market accounts are also like traditional savings accounts but often require a larger minimum deposit to open. The APYs on money market accounts can be higher than traditional savings accounts as well.

Some online banks and credit unions may offer competitive interest rates on money market accounts. However, you won’t find fixed rates as you would with a CD.

These types of accounts often come with check-writing privileges and a debit card. You won’t be penalized for withdrawing money from your account when you need it.

Bonds

Treasury savings bonds, including EE and I bonds, are another CD alternative you may want to consider. With EE bonds, your interest rate (currently 2.70%) stays the same for at least 20 years. The interest rate on I bonds (currently 4.28%) remains the same for six months. You can cash in bonds after 12 months.

Frequently asked questions

Do you pay taxes on CDs?

Unless your CD is part of a tax-advantaged account, the IRS considers the interest you earn on CDs to be taxable income. That means you’ll need to pay taxes on any interest income you receive from CDs during the year you earned it.

Do CDs need to be reported to the IRS?

In most cases, your financial institution should send you a form 1099-INT that shows the interest your CD earned during the tax year. You can use this information when you prepare your tax return. But even if your bank or credit union doesn’t send you this form, you should still include your interest income details on your tax return.

Do CDs pay interest monthly or yearly?

Most CDs feature interest that compounds daily or monthly. Review the terms and conditions of any CD before you open it. If you can find a CD that compounds on a more frequent basis, you can earn more interest over time.

Related Pages: CD rates


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